Weighted cost of capital

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Weighted cost of capital (WACC) is the average weighted of cost of equity capital (ke) and cost of debt (kd).

[edit] Overview

According to the "Modigliano - Miller theory", it states that in a perfect world the WACC would not change regardless on the changes of a company's capital structure. these assumptions are outlined as per bellow:

1. Assume no taxes for both individual and corporate
2. Assume that individuals can be able to borrow at the same rate as the corporate, (known as home-made gearing)
3. Assume that the market is frictionless, that is no costs involved in the transactions
4. Assume that the company has a fixed investment policy being implemented in the strategy of the company.

Furthermore, M&M theory hypothises that the cost of equity capital does change as the company increase its gearing level in the same direction of the gearing level. The reason behind this is because, as the company increase its leverage, the shareholders would therefore require a higher required rate of return as they would bear an additional risk of the company. But the overall WACC doesn't change. They argued that, as company increase the gearing level, the RRR would increase therefore the Ke, but at the same time as they can borroy the debt at a cheaper cost than equity capital, this attraction would likely to be cancelled off leaving WACC unchanged.

[edit] Formulas

The formula is derived by: ke (e/v) + kd (d/v), where v = d + e.

But with the exsitance of taxes in the real world, it does change by the formula: ke (e/v) + kd (1-tc)(d/v), where tc = tax rate of the company.